Word to your portfolio: Rebalance

You can always make a case to regularly retool your account – and this year, it’s especially important.

Normally I rebalance my 401(k) at the end of the year. But considering the losses I have in my account, do you think I would be better off waiting for the market to stabilize before rebalancing? – Samuel Fritts, Cary, N.C.

If you’re a movie buff, you probably remember that famous scene in “The Graduate” where Benjamin Braddock, played by Dustin Hoffman, is wandering through a crowded party celebrating his college graduation when a friend of his parents, Mr. McGuire, pulls him aside to offer some career advice.

“I just want to say one word to you. Just one word. Are you listening?” Weighty pause. “Plastics.”

Clearly, there’s no single word of advice that can address all the issues investors face in today’s perilous environment. But if I did have to limit myself to one word at this time of year, this one would certainly be a candidate: Rebalance.

Yes, I know that rebalancing has become the financial equivalent of your mom’s “eat your vegetables” dictum, a mantra repeated so often that we really don’t hear it anymore. Which is why I often think of rebalancing as the Rodney Dangerfield of investing strategies – it gets no respect.

Truth is, though, that selling assets that have outperformed and plowing the proceeds into those that have lagged (or investing new money into sagging investments) is an easy and effective way of maintaining the right balance between risk and reward in your portfolio.

Quite simply, rebalancing prevents your portfolio from getting too risky when the market is soaring (thus setting you up for a nasty shock when a setback occurs); and it stops your portfolio from becoming too conservative when stock prices fall (leaving you unprepared for a rebound).

And if that’s not benefit enough, research also shows that rebalancing can improve your portfolio’s performance over the long term by smoothing out its ups and downs.

But as solid as the case is for rebalancing on a regular basis, I think it’s especially important to do it this year.

Why? Well, given the beating the stock market has taken this year, the balances of the stock funds in your 401(k) and other retirement accounts have probably declined significantly. Which means that when you rebalance, you will have to shift some of your 401(k) money into those beaten-down stock funds.

I can already imagine you saying, “What? Move money into stocks now? Are you bonkers? That’s the last thing I want to do.”

That reaction is understandable. The stock market has been hammered mercilessly, and no one is sure when the devastation will end. So the natural impulse today – even for someone like you who actually knows he should rebalance – is to stay away from stocks until there’s some assurance that they won’t fall even further. Hence your desire to hold off rebalancing until the market “stabilizes.”

The problem with acting on that impulse to postpone rebalancing until you feel better about doing it is that you’re eliminating one of the main reasons to rebalance: it forces you to buy assets when they’re unpopular.

If you were to always delay rebalancing until a sinking investment recovers – whether it’s stock funds or any other part of your portfolio – you would essentially be buying in mostly when that asset’s price is rising. Do that, and your long-term returns will suffer because you won’t scoop up shares at depressed prices, which is precisely when they’re more likely to deliver superior long-term gains.

In other words, by second-guessing your normal rebalancing routine, you’re undermining the very purpose of the exercise in the first place, which is to take the guesswork and emotion out of managing your portfolio.

That said, it’s also important to remember that rebalancing is a tactical move that makes sense only if you’re doing it as part of an overall plan. Rebalancing is meaningless if you haven’t set an appropriate asset-allocation strategy for your retirement accounts.

After all, if you don’t maintain a mix of stocks and bonds that’s suitable given your age and risk tolerance for your portfolio, then you have nothing to rebalance back to. And if you’ve set an asset allocation that’s inappropriate, then rebalancing back to it wouldn’t do much good either.

Unfortunately, whether it’s because they had no plan to begin with or were unrealistic in setting their stocks-bonds mix, many investors went into this downturn more heavily invested in stocks than they should have been.

The Employee Benefit Research Institute estimates that at the beginning of 2007 nearly 40% of 401(k) participants 56 to 65 years old had 80% or more of their accounts invested in stocks. That’s a pretty high-octane mix for people nearing retirement.

So before you do any rebalancing, you’ll first want to re-assess your investing strategy to assure that you have a mix of stocks, bonds and cash in your 401(k) that’s appropriate for you. (For help creating a suitable blend or evaluating the one you have, you can check out our Ultimate Guide to Retirement.

Once you’ve done that, though, you’ll want to go ahead and rebalance as planned, even if it’s emotionally difficult to do so. Otherwise, you’ll be abandoning your regimen just when it’s likely to do you the most good.